2023-05-17 19:12:55 ET
Summary
- The Charles Schwab Corporation continues to trade at a steep discount, despite strong quarterly and monthly results.
- The current headwinds will become tailwinds, which makes me bullish on Schwab and the financial sector.
- Having said this, the competition in the brokerage space has become intense.
Thesis Summary
The Charles Schwab Corporation ( SCHW ) has come under intense scrutiny over the past few months. Schwab was caught in the regional banking scare, and with good reason, as its balance sheet carries a significant amount of unrealized losses.
With that said, the regional banking crisis is subsiding, and Schwab specifically has seen deposit outflows stop.
Given how depressed valuations are in the space, I believe now is a good time to buy Schwab and perhaps even some of the even more distressed regional banks.
Catching Up With Schwab
Almost two months ago, I wrote about Charles Schwab, calling it a generational buying opportunity. The stock is down around 3.8% since then, but momentum has shifted, with the stock up over 6% in the last 5 days.
Since my last report on Schwab, the company has released its Q1 2023 results :
As we can see, net revenues grew by 10%, while GAAP EPS were up 24%. Not much to worry about on the surface. This is a growing company with solid profitability.
Concerns about withdrawals were also overstated, since Schwab’s net new assets actually grew at a healthy pace.
In the table below, we can see how net new assets have evolved. The first column, from the left, shows the YoY change, followed by QoQ change. Then we can see the total number for the last five quarters, starting with the most recent one, Q1 2023.
Net new assets grew by 175 QoQ, totaling $150.7 billion in Q1 2023. Schwab also benefited from 1 million new brokerage accounts.
Granted, deposits did decrease noticeably, as clients moved cash from their deposits to money market funds:
MMF’s grew by 28%, while bank deposit balances fell 16%. While this does impact Schwab’s ability to fund itself with deposits, there are two key takeaways here.
First off, there is no concern about running deposits, and in April, the bank added another $13.6 billion to its assets.
The other takeaway here is that things aren’t going to stay like this forever. At some point, and I’d argue sooner rather than later, rates will come down, and the appeal of MMFs will decrease, giving Schwab a nice boost.
The Tides Are Changing
Interest rates can’t and won’t stay low forever. With the last Fed meeting, it has become quite clear to markets that this was the last hike of the cycle. Furthermore, the market is expecting rate cuts later this year.
In the tables below, we can see the probability distributions for the next three Fed meetings, according to CMEWatch:
The consensus is pretty overwhelming for the June meeting that rates will be kept the same. For the July meeting, we have a 20% likelihood of a rate cut, and moving out to September, we have almost even odds of a rate cut versus a continued pause.
A regime of lowering interest rates will be great for banks, as this will both increase demand for loans and the value of their balance sheets.
Schwab will profit even more, since it is a brokerage/bank hybrid. With lower rates, regular CDs and MMFs will become a lot less attractive, which will mean a return of inflows into the Schwab brokerage accounts.
Valuation
A rebound in Schwab’s shares seems inevitable. If we look at the historical and peer valuations, Schwab should be trading at least 40% higher from here:
This is the conclusion reached by this Finbox model, which takes historical multiples and peer multiples to determine a fair value for Schwab. According to this model, a P/E of 19 would be more appropriate, which would imply a fair value of $70.97 per share.
A less bullish, yet just as valid, valuation could be obtained by looking for the equilibrium PEG. It is often said that a PEG should be close to 1. So a growth rate in earnings of 20%, justifies a P/E of 20, which yields a PEG of 1.
In fact, 1.01 is the sector median PEG, and Schwab currently trades at a PEG 0f 0.85. To reach a PEG of 1, Schwab’s valuation would have to increase by 17.6%, which implies a fair value of around $59.
So, fair value should be somewhere around the $60-$70 range based on the above calculations.
Risks
This is not to say that The Charles Schwab Corporation stock is without risks. Perhaps the biggest risk is coming from other brokerage firms that could be taking market share from Schwab. Companies like Robinhood Markets, Inc. ( HOOD ) have become very popular with retail investors, which is a demographic that Schwab has benefitted from in the last few years. In fact, the retail volume has declined at Schwab, while supposedly, overall retail volume recently reached an all-time high.
Takeaway
All in all, The Charles Schwab Corporation is, out of the larger banks, one of the hardest hit, and this is why it perhaps offers the largest opportunity. I see the company benefitting a lot from the coming change in the macro environment. Headwinds will become tailwinds, but the market hasn’t realized this yet. I am overall quite bullish on banks too, and I did in fact, advise my subscribers to long regional banks, which so far has played out very well.
For further details see:
Charles Schwab: Houston, We Don't Have A Problem (Rating Upgrade)